3 Biases Investors Are Falling Victim To

After being burned by one of the worst investment bubbles in history, Isaac Newton reflected. "I can calculate the movement of the stars, but not the madness of men."

That's just as true today. It doesn't matter how smart you are. You'll be broke before long if you don't have the right mind-set.

As markets continue to bleed investors dry, all of us would do well to stop, take a deep breath, and spend a few minutes thinking about some of the innate biases that lead investors astray.

Here are three.

Recency biasRecency bias is simply the tendency to think that the future will look like the recent past.

Jason Zweig goes into depth about recency bias in his book Your Money and Your Brain. In the most simplistic terms, the neurons in our brain that hold memories about rewards and punishments from recent events are more active than those of the distant past. "Because your most recent experience carries more weight," Zweig writes, "these neurons evaluate the likelihood of a gain based mainly on the average result of your last five to eight attempts at making money -- with almost all the influence coming from your last three or four tries."

How does this affect investors today? One idea is that with memories of the 2008-2009 market crash still fresh in our minds, investors associate the slightest tingle of weakness as a sign of looming meltdown.

Think about this. One explanation for the recent plunge is that GDP data for the first half of the year was just revised down to 0.8%. That near-zero growth rate worries some that we're slipping back into recession. But GDP growth in the middle half of 2006, when the economy was booming, was also 0.8%. Similarly, many cite this year's job growth of just 133,000 per month as a sign we're falling back into recession. But the same figure for a six-month period in 2006 was 115,000 per month.

Those numbers didn't worry anyone in 2006 because what our biases ignore today was well accepted back then: Economies move in fits and starts. The numbers we've seen lately are usually nothing to worry about.

Could we be headed for another collapse? Sure. But recency bias makes us think the odds are far greater than they actually are.

Confirmation biasConfirmation bias, as Fool.com managing editor Brian Richards summed up, is the practice of "Googling it until you find something that agrees with your point of view."

President Obama recently gave a good example: "Those of you who are of a Democratic persuasion are only reading The New York Times and watching MSNBC, and if you are on the right, then you're only reading TheWall Street Journal editorial page and watching Fox News."

And if you think now might be a good time to sell stocks, odds are you're only reading analysis that persuades you it's the right thing to do -- even if it comes from sources you're unfamiliar with or disagreed with in the past.

Yale economist Robert Shiller has a way of valuing stocks called the cyclically adjusted P/E ratio, or CAPE (more on CAPE here). The logic behind CAPE is powerful, but it's normally only followed by a small group of investors. One reason is because, by CAPE's reasoning, stocks have been overvalued for most of the past 20 years, with recent stock prices perhaps 25% above historic averages. Few investors want to hear that, which is why CAPE hasn't caught on among the general public.

Until markets begin cratering, that is. Then, CAPE goes mainstream. A waveofarticles in the past week have used CAPE to show how much further stocks will fall. Twitter has been abuzz with investors citing CAPE as a proof of an impending catastrophe. There's no way to prove it, but it seems that interest in CAPE jumps by an order of magnitude during market sell-offs. People who hadn't heard of it a week ago become religious followers.

Maybe that's a good thing. CAPE may very well be right. But the fact that investors don't pay attention to it until markets fall is a testament to confirmation bias. The same is true on the way up. Anyone remember Dow 36,000? We read what we want to hear.

The "everyone else is smarter than me" biasI don't know if there's an official name for this one, but it's powerful.

When we see markets plunging, we know someone else is selling. You have no idea who that someone is, but if they're selling, and you're not -- damn, maybe they know something you don't! Instead of asking questions, maybe you should just follow their lead.

Sometimes that's true. But rarely.

Most market activity is done by algorithms that are simply trying to beat one another. Computers following preset buy-and-sell rules now account for more than 60% of total trading.

These computers have absolutely nothing in common with you or me. They're often trying to get in and out of shares in a few hundredths of a second, literally. You're trying to buy good companies for the long haul. They're trying to skim a fraction of a penny off of each millisecond transaction. Plenty more trading is done by hedge fund managers who have to report results to their clients every 30 days. Daily market moves are dominated by those who think the long term means this evening.

Once you come to terms that these folks have nothing in common with you, not only do big market plunges lose their fear factor, but they become opportunities. My colleague Jeremy Phillips elaborated:

Please, Wall Street! Sell off a great company because it missed your quarterly estimates or because some whiz kid analyst thinks the sector is out of favor. You need to window dress the next quarter, I need to fund my retirement in 20 years. I certainly like my odds, regardless of what you choose to do in the short term.

Let the self-proclaimed genius Wall Street traders torpedo markets in the short run. Take advantage of them when they do. They might be able to calculate the movement of the stars, but you can calculate the madness of their behavior.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

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2. The conditions in existence at the time of the decision will persist forever or until the buyer dies.

Why would anyone believe those things can ever be true?

If they are not true then there must be a "SELL" decision which is appropriate for the changed conditions. The author of this article seems to believe that decisions to "SELL" are always an invalid "Panic" response to irrational decisions being made by other "Panic" driven investors. This is patently absurd.

"If you can keep your head when all about you are losing theirs and blaming it on you--You don't know what's happening!"

The average holding period for a stock listed on the NYSE has fallen all the way down to seven months. Over a seven month holding period, the probability that a stock will down ( not up) in price from one's cost basis is more than 70%.

Thus, it seems to me that the market is made up an extremely large group of people who consistently buy after an advance, and sell after a decline.

Of course, this is the exact opposite of how private businesses are bought and sold. Which is yet another reason why most people are not wealthy.

"Buy & Hold" is not "'til death do us part". I searched Mr. Housel's article for, "The conditions in existence at the time of the decision will persist forever or until the buyer dies." and didn't find it. I equally didn't find anything to support, "The author of this article seems to believe that decisions to "SELL" are always an invalid"

Conditions change. Always. That's a given.

Mr. Housel points out that the past two weeks have been particularly rife with headlines announcing "Panic", "Disaster", "Worst Drop", and other such phrases. Those phrases do not impact the underlying facts of any of the companies we have invested in. If something has changes, then re-evaluate your position.

But Kipling's quote which you mock, is truly on point & I'd suggest further you read daveandrae's quote above. A daytrader only makes his broker wealthy.

2. Their activity moves markets up and down in random fashion though nothing "fundamental" has changed.

3. An individual investor should not be influenced by volatility but view downward market movements as buying "opportunities".

There are numerous fallacies and unexamined assumptions inherent in the article:

The "everyone else is smarter than me" bias.

Given the structure of the markets as described (accurately) by the author the market movers ARE SMARTER THAN THE AVERAGE INVESTOR. They have more resources, more training, more support, more access to inside information, analytical techniques, etc. etc. etc. That's why people pay them lots of $$ to do what they are doing! The author assumes they are selling but nothing really fundamental has changed. Well something has changed! A few candidates come to mind:

We are entering a recession (IMHO the recession never ended).

The EU Sovereign debt unwind and related austerity wil lead to credit problems and slowdown in growth at best.

Those who run the markets DO KNOW MORE THAN YOU DO!

When they start selling they do it for a fundamental reason.

Significant market declines are not buying opportunities they are WARNINGS!

Typically, after you've lost 30-40% of your wealth in the decline the clouds will lift, the real drivers of the selling will leak out and the individual investor will discover that he's been screwed yet again.

There are times once/decade when an individual can invest in the stock markets when the valuations are absolutely depressed and provide a margin of safety which will enable a positive return. This isn't one of them.

If you truly believe that there is a secret cabal which controls & manipulates the markets; then you are absolutely right. You have no business participating in a "rigged game".

One can only question then why you bother to read articles on a site dedicated to that "rigged game".

I agree with you that the recession has never ended, though definitions of "recession" become involved.

I would suggest that we are seeing a "race to the bottom" as we saw in the US for say credit card providers about 30 years ago. Those States which provided the most lax regulation of credit cards (cough, cough, South Dakota) saw the Credit Card Providers move to ,and provide jobs to, those States. Now we are seeing the same thing though on a global scale.

They do manipulate, drive and control the markets in the sense that their massive (and highly leveraged) activity dominates the price levels and trends.

IMO it's no longer a market of individual stocks but has become a commoditized asset class in which all stocks essentially move together in whatever direction the "CABAL" pushes it with their massive leveraged dollar volume. For the individual investor the market is a casino.

TA and "fundamental" analysis no longer applies.

I found Mr. Housel's article interesting but superficial and flawed because he didn't seem to recognize the fact that significant market declines are indicative of fundamental changes in opinions of the cabal. They should be feared, respected and responded to by the II. When they leave the Casino you should too.

All 3 biases affect us to different degrees, but there is very good reason to believe that the recent volitility is not a reflection of recency bias or lemming effect, but solid reality.

1. Three words "nineteen thirty seven" FDR's enemies call for an end to WPA and "wasteful" government spending --> austerity budget --> economy contracts and unemployment rises in spite of solid corporate balance sheets. This may fall under confirmation bias.

2. US Postal Service laying off 200,000 American Jobs. where do those people go -- onto unemployment and competing with the other 10% of the country still looking for work. More public employees from federal, state, and local government expected to join them in the next several years.

3. Fear.

That said, I have no interest in trying to time the market or invest based on recent events. I still dollar cost average 7% of my income into equities and 3% into bonds, because I don't intend to retire for 30 more years (aiming at 72 for retirement) . I'm building alternative sources of income not dependent on the market (my own business, annuity). The rest of my investments are rebalanced between equities, bonds, comodities, and cash every 30 months. I manage 1/2 my own equity investments in individual stocks while the other 1/2 is in ETFs that spread my risk around the world.

Now if only I had listened to Morgan and not bought a house, I'd be golden. Sigh.

President Obama recently gave a good example: "Those of you who are of a Democratic persuasion are only reading The New York Times and watching MSNBC, and if you are on the right, then you're only reading The Wall Street Journal editorial page and watching Fox News."

One of the smartest things he's said, and one that will no doubt annoy both sides. Kudos to him.

"But GDP growth in the middle half of 2006, when the economy was booming, was also 0.8%."

Well, I think this is a biased statement. It is normal to have a slow growth rate during economic expansion. It is not so normal coming out of an economic depression.

One question what is the GDP growth for the whole year? Another one is, if the problem is that spending is high enough then why are prices so high? If the housing inventory is so high why are prices not dropping?

We are due for a labor and capital restructing of the economy. When it happens, remember to thank the Fed and Krugman.

Excellent article. The fact that our brains are wired to encourage us to make these sorts of investing mistakes is precisely why financial education is so crucial, and why it's so unfortunate that our existing system of financial and investment education is woefully inadequate. With so few existing sources of accurate, unbiased, up-to-date investment information, The Motley Fool plays a critical role in helping fill our massive vacuum of investment literacy.